The formulas, tricks and trade secrets of Private Equity

Leveraged Buyout Private Equity

Sample Chapter

A leveraged buyout is the typical type of late-stage private equity transaction. The term was more popular in the 1980s during the LBO boom. It basically refers to the buyout of a company using significant leverage.

An LBO works on the premise of levering the investor’s equity to the point that just a small change in the value, or perceived value, of the company triggers a big increase in the value of the equity. Of course this effect works in reverse if the value of the company drops, but PE firms keep this in mind when selecting companies.

They don’t necessarily want to firms that will grow profit, but those that are very stable and may benefit from bolt-on acquisitions and multiple arbitrage.

Leveraged buyouts in private equity involve institutional investors and financial sponsors (like a private equity firm) making large acquisitions without committing all the capital required for the acquisition. To do this, a financial sponsor will raise acquisition debt (by issuing bonds or securing a loan) which is ultimately secured upon the acquisition target and also looks to the cash flows of the acquisition target to make interest and principal payments. Acquisition debt in an leveraged buyout is therefore usually non-recourse to the financial sponsor and to the equity fund that the financial sponsor manages. Furthermore, unlike in a hedge fund, where debt raised to purchase certain securities is also collateralized by the fund’s other securities, the acquisition debt in an leveraged buyout in private equity is recourse only to the company purchased in a particular leveraged buyout transaction. Therefore, an leveraged buyout transaction’s financial structure is particularly attractive to a fund’s limited partners, allowing them the benefits of leverage but greatly limiting the degree of recourse of that leverage.
The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.
A leveraged buy-out (private equity leveraged buyout) is an acquisition that is largely funded by debt. leveraged buyouts are often used by private equity firms as a way in which to make large acquisitions that they would not otherwise have the resources for.
The type of debt depends on the circumstances in which the money is raised. One method is the issue of bonds by a company set up especially to carry out the acquisition. The aim will be to repay the bonds with the cash flows of the target.
If the bid fails the acquisition vehicle may not enough money to repay the bonds. The default rate on leveraged buyout bonds is high: these are very much junk bonds.
leveraged buyouts also frequently use bank debt, borrowings form other financial institutions, and mezzanine finance. A single leveraged buyout (especially a large one) may use several types of debt.
Once an leveraged buyout is completed, the result is a highly geared business. This means that a good target for an leveraged buyout would have strong stable cashflows, low levels of existing debt and a strong balance sheet (assets to back the new debt).
A successful leveraged buyout also usually requires an exit strategy. Many private equity leveraged buyouta have been broken up and sold, so a large part of the impact of those leveraged buyouts was creating shareholder value by breaking up a conglomerate. This was particularly true at the time leveraged buyouts first became common in the 1980s. Although leveraged buyouts occurred before then, the technique was popularised in the 70s and 80s by American private equity firms such as Kohlberg Kravis Roberts.
To finance leveraged buyout’s, private-equity firms usually issue some combination private equity of syndicated loans and high-yield bonds. Smaller transactions may also be financed with mezzanine debt from insurance companies or specialty lenders. Syndicated loans are typically arranged by investment banks and financed by commercial banks and loan fund managers, such as mutual funds, hedge funds, credit opportunity investors and structured finance vehicles. The commercial banks typically provide revolving credits that provide issuers with liquidity and cash flow while fund managers generally provided funded term loans that are used private equity to finance the leveraged buyout. These loans tend to be senior secured, floating-rate instruments pegged to the London Interbank Offered Rate (LIBOR). They are typically pre-payable at the option of the issuer, though in some cases modest prepayment fees apply.[3] High-yield bonds, meanwhile, are also underwritten by investment banks but are financed by a combination of retail and institutional credit investors, including high-yield mutual funds, hedge funds, credit opportunities and other institutional accounts. High-yield bonds tend to be fixed-rate instruments.
A leveraged buyout or LBO is a type of aggressive business practice whereby investors or a larger corporation utilizes borrowed funds (junk bonds, traditional bank loans, etc.) or debt to finance its acquisition. Both the assets of the acquiring corporation and acquired company function as a form of secured collateral in this type of business deal. Often times, a leveraged buyout (LBO) does not involve much committed capital, as reflected private equity by the high debt-to-equity ratio of the total purchase price (an average of 70% debt with 30% equity). In addition, any interest that accrues during the buyout will be compensated by the future cash flow of the acquired company.
The most common buyout agreement is the management buyout or MBO. In this corporate arrangement, the company’s management teams and/or executives agree to “buyout” or acquire a large part of the company, subsidiary, or divisions from the existing shareholders. Due to private equity the fact that this financial compromise requires a considerable amount of capital, the management team often employs the assistance of venture capitalists to finance this endeavor. As with traditional private equity leveraged buyouts, the company is made private and corporate restructuring occurs. Many financial analysts will agree that MBOs will greatly increase management commitment since they are involved in the high stake of a company.

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